by Robin Marshall, director, fixed income research
China’s arrival in global indexes changes the nature of the asset allocation decision for global investors benchmarked against them. Investors may now need reasons to justify not investing strategically in Chinese government bonds, rather than a justification for doing so tactically when they were not included in benchmark indexes. Since foreign holdings of Chinese government bonds have been low historically, there is the potential for them to rise significantly.
Foreign holdings of Chinese govt bonds have risen but are still low versus major markets…
Foreign private sector holdings in renminbi assets have been low generally relative to other major markets[1], particularly in Chinese government bonds. Although they have reached about 10% of the total outstanding (as of Q4 2020), from only 2% in 2016, they still lag foreign holdings of nearer to 30% in the US and UK markets as Table 1 shows.
…several various reasons, some historical and some due to classification
However, the low weighting in foreign ownership of renminbi assets and Chinese government bonds is not a surprise, for a number of reasons. First, Chinese financial markets were relatively inaccessible to foreign investors until recent reforms, such as the decision to include the renminbi in the IMF’s Special Drawing Rights (SDR) program in 2016. Second, concerns about liquidity in Chinese government bonds may have been another factor reducing foreign ownership. Third, Chinese government bonds have been designated an Emerging Market (EM) for bond index purposes, and therefore not featured in global indexes until recently. Thus, China joined the FTSE Russell Emerging Market government bond index in January 2018 but will not begin to enter the FTSE Russell World Government Bond Index (WGBI) until October 2021, for example.
Various factors mean the asset allocation decision is changing for global investors…
Whether, and indeed how quickly, private investors and official entities, like central banks, might move towards benchmark/SDR weights will depend on market valuation and returns, ease of access for investors, currency convertibility and outlook, and market liquidity in renminbi assets.
On valuation, the high relative yields in Chinese government bonds, given China’s sovereign credit rating of A+, and the short duration of market indexes are a clear contrast with G7 bonds, as can be seen in Table 2. These high yields, despite the short duration and A+ rating, suggest the Chinese market is modestly rated versus G7 markets.
Low foreign participation in the Chinese government bond market also means the correlation of returns between Chinese and G7 bond markets has been low[2]. Indeed, Chinese bonds withstood the recent sharp back-up in US treasury yields, with yields barely rising[3], and low correlation of returns also offers portfolio diversification benefits.
Chinese government bonds issued in renminbi do carry currency risk for overseas investors, like all local currency govt bonds, but this should be set against China’s favorable net international investment position, currency reserves of over US$3 trillion and ongoing trade surplus. These factors reduce the probability of pronounced weakness in the renminbi, which would likely attract the ire of trading partners, and accusations of currency manipulation (as it did during the Trump administration).
...and the liquidity challenge appears to be easing
Finally, liquidity metrics for both the government, and policy bank bond markets, suggest some improvement in recent years, as foreign participation has increased, and the PBOC now conducts monthly secondary auctions with market makers, designed to improve liquidity. However, longer dated government bonds tend to be less liquid, with lower free floats, since high proportions of these issues are held by domestic insurance institutions and are not frequently traded. This may slow the speed with which investors move to benchmark weights, although liquidity in G7 government bond markets has not been guaranteed at all times during the COVID-19 crisis.
So potential inflows into Chinese govt bonds could be substantial, assuming more “normal” portfolio weightings
Assume private investors move to a benchmark index weight in the WGBI, of 5.25%, in the 36 months from October 2021 onwards, and US$2.5-3 trillion in global asset under management currently track WGBI[4]. Then potential capital inflows into the Chinese government bond market would amount to US$130-$158 billion. But this would be supplemented by sizeable official inflows into RMB assets, of a further US$207 billion, if foreign central banks increase their weightings in RMB assets, to about 7.25% of total holdings, which would still be well below the RMB’s 10.9% weighting in the SDR[5].
For more information, please see our paper.
[1]See “Chinese government bonds; characteristics and evolution” FTSE Russell, March 2021.
[2] See Chinese government bonds ‒ characteristics and evolution, FTSE Russell, March 2021.
[3] See China Fixed Income Monthly, FTSE Russell, April 2021.
[4]HSBC and State Street estimates.
[5] See “ WGBI inclusion confirms China’s arrival on global bond stage “, FTSE Russell, May 2021
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